From the book “Restoring Financial Stability: How to Repair a Failed System”. Section V: The Role of the Fed

Background

As we work our way through the current financial crisis, central banks have shifted their attention from managing short-term interest rates to providing liquidity to the financial system. In the US, for example, the Federal Reserve’s balance sheet has expanded rapidly, as it offered funds to banks and accepted securities in return: from under a trillion dollars in August 2007 to over two trillion in November 2008, expanding primarily through its lending to banks against illiquid collateral. This “lender of last resort” (LOLR) role is neither new nor unusual, but its massive scale suggests that it is worth some thought to get the details right. We make below what may seem right now to be a perverse argument: Central banks can learn something from the private sector about how to manage its provision of liquidity.

The instant he takes office, President Obama’s imme diate priority must be to fix the economy, which is spiraling downward rapidly in the worst financial crisis since the 1930s. The clear answer is a combination of government spending (the “stimulus package”) and financial restructuring – and the latter is the more important.

There is a tendency in a crisis to throw out the rulebook: we are in a unique situation, some will say, and that calls for unique measures. In fact, financial crises are recurring events whose history has taught us some clear lessons. One is that policy responses can make things worse if they are not […]